Head of U.S. Investment Specialists, Global Fixed Income
In Brief
- The rise in bond yields has created a generational opportunity across fixed income markets, allowing investors to earn meaningful income while improving the diversification benefits of bonds within balanced portfolios.
- Healthy economic growth, a stable labor market, and historically strong corporate revenues and profit margins reflect a more robust economy consistent with today’s higher-rate regime that is likely to persist.
- A higher starting yield has historically been an indicator of a higher expected return, making bonds more competitive compared with equities with a fraction of the risk.
- Active fixed income managers have the ability to capture additional yield and returns by moving beyond the constraints of the benchmark index and into credit-oriented sectors of the market supported by strong fundamentals.
Why bonds deserve a closer look
Interest rates have reset higher to levels last seen at the start of the century. That means bonds once again offer meaningful income, giving investors a buffer they simply did not have before. With yield doing more of the heavy lifting, investors no longer need to make a perfect call on the direction of rates to put fixed income to work. In a higher rate environment, time in the market beats timing the market.
The recent rise in yields has created compelling value across the global bond market, with many sovereign bond markets now offering yield levels not seen in nearly two decades. Notably, the 10-year Treasury yield has spent less than 10% of the time above 5% so far this century. Over the last three years, since the Fed ended its last hiking cycle, it has traded between 3.75%-4.75% about 93% of the time. Today’s higher range is reflective of the return to a more normal bond market and higher-rate environment that is likely to persist, rather than the start of an aggressive hiking cycle.
Healthy economic growth and moderate inflation provide a strong foundation for fixed income investors. Higher interest rates create an “income cushion” that is more powerful than it often appears. Yield accrues continuously, helping to offset price volatility and reduce the sting of modest rate increases, contributing to a steadier return profile over time.
Despite what may feel like a volatile environment, given elevated geopolitical and policy uncertainty as well as rapid technological change, rangebound interest rates at already high levels have translated into meaningful returns for bond investors. Over the last three years, the Agg has returned 4.06% annualized, while high yield bonds have delivered 8.02% annualized1. With starting yields having reset higher and the yield curve steeper, history suggests the forward return outlook for fixed income is compelling.
The exhibit below shows that where yields start has historically determined where returns end up, and that pattern has held remarkably consistently across decades. At current yield levels, that history points to a solid five-year outlook for core bonds.
With roughly 49% of the U.S. bond market excluded from the Agg, passive strategies have limited scope to generate income. Active managers, with the flexibility to allocate across sectors and securities outside the index and to actively manage duration, may be better positioned to access a wider range of yield opportunities. More broadly, a higher-rate environment restores bonds as a meaningful portfolio-building block for diversification, income and stability.
Against this backdrop, the central portfolio question becomes how bonds should be deployed to serve investors' specific goals.
1. Diversification
Beyond income, one of the most significant changes in today's bond market is the improved diversification potential that comes with higher yield levels. For much of the low-rate era, bonds offered limited protection against economic or market shocks, as yields had little room to fall and offset weakness in risk assets. Today, higher starting yields provide a larger cushion against volatility and increase the potential for bonds to serve as an effective portfolio diversifier.
With the federal funds rate having reset significantly higher since 2022, the Fed now has meaningful room to cut rates if economic conditions were to deteriorate. While not our base case view, that matters because falling rates are a tailwind for bond prices, and today's higher starting yields mean the potential price appreciation in a risk-off scenario is far greater than it was just a few years ago. In fact, across most fixed income sectors, the potential gain if rates were to fall outpaces the potential loss if rates were to rise, a dynamic that was largely absent during the low-rate era. The chart below illustrates this improved asymmetry across fixed income sectors.
2. Income
A resilient economy has resulted in another year of strong returns for credit and income-focused strategies. For example, the High Yield Index has outperformed the Agg by over 4% annualized over the last 5 years. Credit sectors have the potential to continue to perform and may be well-positioned to capture attractive yield and total return.
And the opportunity doesn't stop at the index level. As the chart below illustrates, active managers who look beyond the broad investment-grade index, which yields around 6%, can find tactical income in investment grade subsectors such as subordinated bank debt, hybrid securities from utilities and energy companies and select hyperscaler debt, with yields over 7%.
For taxable accounts, municipal bonds offer an attractive tax-equivalent yield of over 8% with the safety of a government-backed sector. Municipal balance sheets are healthy with strong rainy day fund reserves, in stark contrast to the federal government.
High-income bond strategies can offer yield and total return in the high single digits, effectively delivering equity-like returns with a fraction of the risk of equity markets.
3. Stability
Investors have continued to flock to cash-like instruments for yield and stability, more than doubling the assets under management in money market funds over the last 10 years to over $8 trillion2, underscoring how much of the market remains parked on the sidelines rather than capturing today's full yield opportunity. While cash remains a viable asset class, cash rates have moved steadily lower by roughly 175 bps to below 4% as the Fed has cut front-end rates. A steeper yield curve provides investors with an opportunity to capture additional yield and total return while maintaining stability by stepping out of cash and into the front end of the yield curve.
For example, the 1–5-year investment-grade credit index provides a yield of 5.0% with a duration of 2.6 years. A 100 bps decline in front-end rates would drive a total return near 7% for the year; a 100 bps rise would still deliver a return near 3%. The attractive asymmetry in the front end of the yield curve is supportive of investors taking a step out of cash.
Rebalancing toward a stronger portfolio
The reset in yields has done more than restore income, it has fundamentally improved the competitive position of fixed income as an asset class. For investors accustomed to reaching further out on the risk spectrum just to generate a reasonable return, today's environment offers a more balanced path forward.
From the perspective of a whole portfolio, significant gains in equities over the past five years have left many investor portfolios over-allocated to stocks. Based on analysis by the J.P. Morgan Asset Management Market Insights Team, a typical 60/40 stock-bond portfolio from 2019, without rebalancing, would now be a 74/26 portfolio—meaning that investors are now unintentionally exposed to a greater amount of risk.
A higher interest rate environment presents an opportunity for investors to realign portfolios that have drifted toward excess equity risk, because bonds can once again contribute meaningful income and improve the risk/return profile of a diversified allocation.
The case for the traditional 60/40 portfolio has been meaningfully restored. With bonds once again offering competitive yields and the potential for price appreciation in a risk-off environment, a balanced bond allocation offers investors a way to participate in market upside while maintaining a meaningful buffer against volatility.
Investors should strive to embrace the current rate environment. As zero interest rates and negative yields are becoming an increasingly distant memory, bonds are reclaiming their status in a diversified portfolio.